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Monday, March 13, 2006

California Fees for Limited Liability Companies Held Unconstitutional

Most limited liability companies ("LLCs") in California are treated as partnerships for federal and California income tax purposes, and therefore are exempt from federal and California income taxes. The income taxed taxed on the returns of the "members" of the LLC. However, any LLC that is organized, registered, or doing business in California generally is required to pay an $800 annual franchise tax as well as an additional fee based upon the LLC's total income. The fee can be as high as $11,790 for an LLC with total income of $5,000,000 or more, and is zero for LLCs with total income below $250,000.

In recent case called Northwest Energetic Services v. California Franchise Tax Board, a Superior Court judge in San Francisco ruled that this additional fee violates the United States Constitution because it is based upon an LLC's total income, rather than solely upon that portion of the LLC's income that is fairly apportioned to California. As a result, LLCs may not be required to pay the Annual Fee and may be eligible for refunds of amounts paid in prior years. Click here to read a copy of the judge's ruling.

The facts in were somewhat unusual because LLC was registered to do business in California, but did not actually have any operations or conduct any business within the state. The court did not address the constitutionally of the fee imposed on LLCs that do have California business or operations. It is possible that the courts would deem this additional fee unconstitutional in its entirety. The more likely result, however, is that the courts would hold that the additinal fee partially constitutional to the extent that LLCs may be required to pay a portion of the fee upon the percentage of their business and operations within California. It is even possible that the original holding will be overturned on appeal.

Moving forward, it would not appear difficult for California to revise the fee so that it satisfies constitutional requirements. By incorporating an appropriate apportionment mechanism (such as already exists for other California taxes), and adjusting the overall fee rate, California could maintain the same level of revenue that it historically received from this fee.

Thus, the precise impact of this case will remain unclear while the case is on appeal. LLCs that are or have been organized, registered, or doing business in California must consider whether to pay the fee and whether to apply for a refund of Annual Fees paid in prior years. For some LLCs, the amount of the Annual Fee is small relative to the costs of seeking a refund. On the other hand, the potential refund could be quite large. LLCs may be entitled to refunds only for "open" tax years, which potentially means that the decision to seek a refund for the most distant open years must be made quickly. Thus, each LLC should promptly consult with its tax advisor to determine the most appropriate course of action.